CASE 45

STINSON PAVING FINANCIAL LEASE

STINSON PAVING FINANCIAL LEASE
Stinson Paving, specializing in the development and construction of private roads, was started
in 1951 by Tim Stinson. His younger brother, Jeff, became a partner in 1960, and the firm
grew despite the fact that neither brother was especially ambitious or aggressive in seeking
new business.
By 1990 annual sales totaled nearly $3 million when the brothers sold the business to Phillip
Hartman. Hartman proceeded to diversify the firm's con- struction business and actively
sought state, local, and federal contracts on roads and bridges. And Hartman has been
successful. Sales in 1996 exceeded $8 million, primarily because of the firm's extensive
government highway contracts.

BONDING
One key to obtaining government contractes has been Stinson's bonding cap ity, that is, its
ability to obtain surety bonds. These bonds are issued by sunety companies (often a large
insurance company liike Aetra) and are a guarantee that the contractor has sufficient funds to
complete any project the firm is bidding on. A surety bond is therefore a form of insurance
and in essence is protection against frivcanas bidding by contractats.
The ability of a form like Stinson to obtain such bonds is a prerequisite to doing any
significant construction project, Indeed, the Miller Act of 1933 makes it mandatory for firms
to have a sunety bond to obtain federal contrach, and most state and local government
projects nequite one as well. It is easy to that a firm's bonding capacity (the masimum vahe of
the bonds a sunety com pany will extend to a contractor) sets a clear limit on the contractor's
business. It is also easy to see why sunety bonds have frequently been called "the lifeline of
the curetraction industry."
Obtaining sach bonds is becoming more difficult, however. Many sunety com parties
incarnisd significant loses in the mid to late eighties and some even left the ing custs are
likely to rise sharply and bonding nequirements will surely stiffers.
Hartman is ver very protective of the firm's bordability and astlines that a surety company
loclos carefully at a contractor's balance sheet as well as its technical expertise and
weputation. He has always been eager to maintain as low a debt ratio as possible in order to
present a strong balatice sheet. This debt- ratio concern is especially troublesome to Hartman
given the tightening of bonding standards and is something of an issue regarding two new
scrapers the company needs.
A scraper is used in soad construction and essentially moves dirt from one spot to another.
The firm has decided that it wants two Caterpillar 627 scrарев, which have a "out to fill"
raruge of nearly 6 yards. That is, the scrapers can nomuve dirt and transport it to another anca
up to fl yard away, quite a large distance for this type of equipment.
These scrapers cont SKKK each and Hariman is not clear how they should be financed. His
first reaction was to use all equity, which would lower the firm's debt-to-equity ratio. A
conversation with the firm's bariker, however, made it quite tempting to bornow the needed
funds. The bank is willing to lend at 100 percent, a rate Hartman finds a hit tempting. He
believes that inflationary expectatiairw an rising, which should result in higher internet rates
A LEASING PROPOSAL
The financing waters were further muddied when Hartman received a leming proposal from
WIE Capital, one of the natiory's largest and most imputabile leas ing companies. The lease
would run five years and include sis yearly payments of STUM each, with the first payment
due immediately. The lease cellable and Stirsan Paving must pay off the entire contract if it
warts an "early cut. Stinem Paving would abo be nespornsible for the annual insurance and
maintenance expenses of $1,000 and $25,000 respectively, In addition, the truckos
could be purchased at fair market vahe at the end of the leasing term. What Hartman finds
attractive, however, is the fact that WIE claims the lease can be structured to saep it off the
balance sheet. Isco, Hartmann POTS, The can present a stronger balance sheet to surety
companies than if he burmowed the funds. His initial reaction to the lesise is quite favorable.
It seems to involve the advantage of debt, a fixed and presumably "low" bornwing cost,
without the balance sheet disadvantage of debt.
Hartman has reviewed the financing possibilities with Tina Montieth, the firm's accountant.
Montieth said she will evaluate the keuse but needs to know how Hartman intends to finance
the scrapers if the lense is not selected. When
Hartmm asked why this was necessary, Montieth said this dictates the interest rate she will
use in the evaluation
If the funds were borrowed, she explained, the after-tos borrowing rat would be appropriate.
If all equity were used, then a li peramt after-tax rate, a combination of debt and equity, she
would them evaluate the lease using the fam's weighted average cost of capital (WACC) of 14
percant. She will also assume, for the purpose of analysis, straight line depreciation over five
yours-on the full cost of the scrapers. The relevant tarx rate is 40 percent
A BETTER DEAL?
Montieth also said it may be possible to bargain for abether ksasing payment from WIE. An
important factor in setting these payments is the residual value sumption sound by the lesesor,
that is, the meamed market value of the scrap ets at the end of the contract. A low residual
valur ireplies high annual payments. If she could amvince WIE that des residual value was
too conserva tive, she believes she could obtain a anwer amual payment. One difficulty,
though, is that the lesseur's neidual value estimate is considered confidential information and
is not nadily available. Montieth, bowever, believes she can deduce the figure WIE is using
Hartman feels that the scrapers, given proper maintenance and normal use, have an economic
life of 10 to 15 years. And he thinks that a "very masenable" estimate is that in five years the
scrapers will be wurth 40 percent of their orig inal cost. He believes that an independent and
objective appraisal would reach the same figure. He admits, however, that this estimate is
about as pre cise as any other brusdreses forecast the firm makes. A "quite courservative and
probably lower limit" predictam would be 25 percent. That is, Hartman believes it is unldarly
that the resichual value of the scrapers in live years will be less than 25 percent of their
original cost.
QUESTIONS
1. Evaluate Montieth's argument that the interest rate used to evaluate the use
depends on how the scrapers would be finariood if the leaser is not selected.
2. What is the appropriate residual vahar estimate to use in the lease evalua tion? Fixplain
1. Calculate the NPV of the lesse
4. (1) By accounting custventions, ita lease medis any of the following condi tions it is
classified as a capital lease and must be shown directly on the balance sheet.
1. The base transfers nwnership of the asset to the lessee before the kevese
The lease allows the lessere to purchase the asset at a bargain price.
iii. The term of the lewe is equal to, or greater than, 75 percent of the anet's estimated useful
life.
iv. The prissent value of the lease payments is equal to, or greater than, 0 percent of the
weer's mariat value.
Will the lease Hartman is considering appear dinestly on the balance sheet Explain.
(b) One factor that surety companies look at is a firm's debt ratio. Hondability is enhanced
with a low debt ratio, If this levese is selected, how will the debt ratio look compared to a
luan? All equity? Explain your arwwwer
5. Hased on your previous answers and other informatan in the case, how do you think the
scrapers should be financed? Justify your choice.
6. Montieth thinks she may be able to negotiate a better vase payment in part because she
believes the leasing company is using a madual value estimate that is too low
(a) Why would a low noodual value assumption result in a high lease paymerit?
(b) The pre-tes wtum and residual value assumption used by the lesser ane considered to be
confidential information. Fortunately for Montieth, a com fidant has informed her that the
leasing company strives for a 12-percent befume-tax notum, Armed with this information,
what nesidual value sti mate is the leasing company using
7. (a) Assume the lowing company wants a 12 percent before-has return. Montieth can
corwiner WTE that a 5120100 per scraper nesidual value is appropriate, what annual kasing
payment would WTE give Stinson Paving
(b) Does this affect your arower to question ? Explain.
Questions & Answers
1. Evaluate Montieth's argument that the interest rate used to evaluate the use